Forex Market Driving Forces

There are a few key forces that cause currency prices to fluctuate relative to one another. All of these factors work in line with each other, rather than stand alone to effect currency prices. It is however important for a trader/investor in the currency markets to pay attention to some or all of these factors when making trading decisions, as they may have short or long term impact on the market.

Interest Rates

Typically people and businesses want to borrow with a low interest rate and lend with a high one. An example of this is the Pound Yen Cross (GBP/JPY). The GBP/JPY cross can provide traders with a an opportunity because they are borrowing the Japanese Yen at a low interest rate and using it to purchase and hold the British Pound at a higher interest rate, which allows the investor to make the money on the interest, as long as the currency pair does not depreciate in value. Obviously this is an ideal situation and there are many other factors involved but this is the outline of how the carry trade works.

Below is a weekly chart of the GBP/JPY cross: As you can see from 2005 to 2007 the GBP/JPY cross appreciated in value. This is because many investors would be drawn to collect the interest from being in this position. Once the interest rates in UK started to decrease and the economic situation in the US and UK started to worsen the GBP/JPY cross started to depreciate. This chart depicts this situation.

Economic Growth

Typically people want to invest where money will grow faster. When you are purchasing a currency you are actually investing in a country. This means that as the country's economy strengthens the currency should appreciate as more people are likely to also want to invest in that country. Of course other factors mentioned here are in play but that is the basic theory of economic growth a stand alone factor.

Below is an example of the EUR/USD currency pair chart from January 2007 until March 2008. As you can see, the economy in the US has been declining relative to the economy in Europe, the value of the Euro appreciated relative to the US Dollar.

Geo-Politics

People want to keep their money in safer and more stable countries and areas of the world. Basically a negative situation in a country can be a danger to the economy and thus the value of a currency. Obviously, instability will diminish investment in a particular country thus decrease the demand for its currency, relative to other more stable currencies.

Trade and Capital Flows

Import/Export trade balance effects currency price. If a country has more exports than imports then businesses demand the country's currency which has an upward effect on the currency price. Investors should stay on top of significant noticeable changes to a countries trade balance and keep track of economic reports regarding this factor.

Merger and Acquisition Activity

When companies in foreign countries make large transactions they need to accumulate large amounts of currencies in the markets, as they do this throughout the day, there may be an impact on the values of each countries currency involved. Next >